'Mutual funds can charge up to 5 per cent of assets under management annually,' said Matt Rickard, the head of dealing at British broker Hargreaves Lansdown.

The Tracker Fund of Hong Kong is one popular, locally listed ETF. This straightforward fund buys and holds every security in the Hang Seng Index. Investors in the fund, managed by State Street Global Advisors, then own a small fraction of each stock on the exchange.

This is useful if you want a balanced portfolio of local stocks but cannot afford to buy the minimum lot of each listed company's shares. To own HSBC, for example, investors must buy at least 400 shares.

At current prices, that would be around HK$14,000. Or, you could buy the minimum 500 shares in the Tracker Fund, for around HK$6,000.

Unlike mutual funds, ETFs are not actively managed by highly paid fund managers who, with a team of analysts, buy shares based on the expectation of future performance. An ETF has holdings in every company on the index it tracks and only buys and sells holdings to reflect movements in the market.

'The traditional ETF buys, holds and sells constituent stocks of an index to track that index,' Rolfe Hayden, a lawyer with the Hong Kong office of Simmons & Simmons, said.

Hong Kong investors do not have much choice of ETFs on the local market. Only 24 are listed here. The Tracker Fund came first, in 1999. Since then, the world's largest providers of these funds, including Barclays' iShares and Lyxor (part of French bank Societe Generale), have gradually introduced more.

But Hong Kong still does not offer ETFs tracking the full range of emerging markets or commodities. There are China, Russia and India funds, but no offerings for Vietnam or Brazil. There is a gold fund but no oil fund.

ETFs were introduced in London in the early 1990s and had a similarly slow start, not really gaining popularity until around 2001. There are now over 200 ETFs on the London exchange.

Sluggish ETF uptake has been blamed on financial advisers being motivated to keep them a secret.

In Hong Kong and London, ETFs are sold through independent stockbrokers and the stockbroking arms of banks.

Financial advisers, by comparison, do not sell stocks. They sell actively managed mutual funds and receive commissions from fund-management houses for doing so. So why would they recommend clients visit a stockbroker and buy ETFs? The product took off in London only after it was popularised by the financial media.

Investors interested in a wider range of ETFs than just those listed in Hong Kong could consider London-listed funds. There are over 200 ETFs on the London Stock Exchange, offering exposure to everything from global telecommunications stocks to coffee.

'Hong Kong investors can buy [ETFs] in Hong Kong or on any other exchange, as long as they have brokerage access into those exchanges,' said Joseph Ho, Lyxor's head of ETF sales for Asia. All investors need is a broker to help them buy foreign stocks.

Unlike in the United States, which presents an almost unmanageable time difference, the London Stock Exchange opens for trading at 8am, or 4pm Hong Kong time.

But before leaping into ETFs, investors must understand what they are buying. Not all ETFs are created equal, and some present unpalatable risks.

Professional financial advice, either from a stockbroker, a private banker or a financial adviser who can be persuaded to discuss ETFs honestly, should always be sought before buying these products.

But as a rule of thumb, experts say, ETFs that either buy shares or hold assets such as gold are probably the safest. If a financial institution involved in providing an ETF went bankrupt, the fund should own something that can be sold quickly so investors get their money back.

The SPDR Gold Trust, traded in Hong Kong, looks fairly safe. It sells shares equal to 0.1 per cent of an ounce of gold. But most importantly, in owns the gold that investors buy shares in. Gold equal to the value of the fund is stashed in HSBC's vaults in London. SPDR's prospectus discusses this in more detail.

Any fund that holds only shares is similarly low-risk. ETFs that buy shares will deposit them with a custodian bank. If the ETF manager goes bust, the custodian would find a new manager. And if the custodian bank goes bankrupt, according to Freshfields partner Perry Sayles, the ETF might stop trading while the bank went through liquidation proceedings. But shareholders would eventually get their money back. That way, ETFs are safer than an individual companies' stock. If a company goes bankrupt, equity investors get nothing.

Potential problems arise, however, when ETFs do not own physical assets or shares. These funds tend to offer exposure to difficult-to-own commodities, such as wheat, coffee or livestock. They also tend to use derivatives. Derivatives contracts involve more than one financial institution, and if either of the financial institutions goes under, it can mean real trouble for ETF investors.

Last September, investors in some popular commodity ETFs managed by ETF Securities and listed in London, got a huge fright. On a single day, stockbrokers suddenly stopped buying and selling over 100 ETF Securities products that owned derivatives contracts with ailing US insurer AIG on the other side. The ETFs plunged in value, in one case by 80 per cent.

Credit ratings agencies had downgraded AIG's debt, leading to bankruptcy fears, which have since been resolved by US government bailouts.

The ETFS fund, which fell 80 per cent on that day last September, did not own anything. It was offering exposure to 'live cattle and lean hogs'. Because it could not buy the animals, the manager placed bets with AIG on the future prices of cows and pigs. So all that ETF investors owned were a collection of contracts with AIG relating to hog and cattle prices on world futures markets.

The contracts were very simple. If the price of pigs and cattle rose, AIG would pay the gain to the ETF and its investors. If the prices fell, the ETF would pay AIG for the loss. It worked beautifully until brokers started fearing AIG would go bust.

If AIG had gone under, the contracts could have been worth nothing. As the ETF owned nothing else, its market capitalisation would have crumbled.

ETF Securities resolved the situation, and a spokesman said no single investor lost money because of last September's events.

But, just in case, AIG now deposits cash and government bonds worth the same amount as the market value of the ETF Securities funds it works with in a special account with Bank of New York Mellon. So if the insurer suddenly cannot honour its contracts, investors in the ETFS funds would be paid cash worth the same as their shares, the ETF Securities spokesman said.

The AIG scare happened before most governments around the world started to bail out troubled financial institutions. There is arguably less chance of a big bank or insurer going under now.

'Given the various governments' backing for banks around the world, I personally think the counterparty risk is now technical,' Mr Hayden said.

But other experts remain unsure of the risks attached to ETFs that own only paper contracts.

As Mr Rickard said: 'It is a very grey area where previously unthought-of risks have emerged, and the whole industry is still struggling to fully understand all the potential problems.'

And Mr Sayles advised: 'Read the prospectus carefully and look out for references to 'swaps' or 'derivatives'.'

An ETF provider's marketing department should also be able to help investors who cannot understand the legal and financial jargon in a fund prospectus.

Slim pickings

Hong Kong investors are looking at a small pool when it comes to ETFs on the local market

The number of ETFs listed in the city is: 24

ETFs on the London exchange number more than: 200